Cash-Out Refinance: What Is It and When to Use It
Points of Interest
Cash-out refinancing can get homeowners to access cash built up in their home’s equity fairly quickly. But before pulling the trigger, make sure you understand the costs and potential risks.
When you need cash, you have several unique options as a homeowner. One of these options worth considering is a cash-out refinance. This lending tool allows homeowners to tap into their home’s equity without needing to sell the home.
Before you call up a lender and start the refinancing process, take a few minutes to understand the ins and outs and the pros and cons of the process. A cash-out refinance can get you the money you need for things like home improvements, debt consolidation, medical bills, and anyone of many other uses. But you are going to be adding to your mortgage debt, and there are additional costs and risks.
What is a cash-out refinance?
Refinancing is the process of taking out a new mortgage loan with new terms, rates, and repayment factors. The new loan is generally for the same amount that you currently owe. This new loan pays off the old loan, and you now only have to pay on the new refinanced mortgage.
With a cash-out refinance, though, the new mortgage loan is for a higher dollar amount than what you owe on your existing mortgage. The dollar amount difference that is not used to pay the old loan is paid out to you in cash.
For example, let’s say you owe $100,000 on your mortgage still. A traditional refinance would get you a new loan for $100,000. All of that money would go towards paying off your existing mortgage. With a cash-out refinance, though, you might get a new mortgage for something like $140,000. The first $100,000 goes to pay off your old loan and the remaining $40,000 goes to you in cash. While this seems excellent, remember you now owe $140,000 on your mortgage instead of the $100,000 you owed before refinancing.
When to use a cash-out refinance
Deciding when it’s the right time to use a cash-out refinance depends solely on your financial situation, your current mortgage terms, how much cash you need, and what you need it for. First, you will need to have equity built up in your home to do a cash-out refinance. Most lenders limit the amount you can take out to 80% – 90% of your home’s equity. If you don’t have enough equity built up to get the amount you need, it’s not going to be the right move.
You’ll also need to look at the rates and costs associated with the refinance. Remember, once you refinance, you’re no longer bound by the old loan’s terms but by the new ones. If your new loan is significantly more expensive, it does raise the cost of borrowing indirectly.
You will be paying closing costs on the refinance. Weighing this into the equation is critical to deciding when to use a cash-out refinance. Additionally, by adding more debt to a secured loan, you do increase the risk of that loan. This is especially true if you’re consolidating unsecured debt into a secured debt loan.
To mitigate some of these risks, take time to shop for your different options, and consider all the costs. If you’re worried about approval, you can always look into something like an FHA refinance that does also have a cash-out option.
Difference between cash-out refinance, and limited cash-out refinance
When it comes to refinancing, it’s easy to get lost in all the different options. Are you looking for cash-out refinancing, a no cash-out loan, or a limited cash-out refinance? It’s critical to understand the differences before deciding. A cash-out refinance is a mortgage loan that gives the homeowner more than $2,000 in cash. The cash comes from the equity the homeowner has built up in the home.
On the other hand, a limited cash-out refinance is a refinance where the owner is capped at receiving $2,000 or 2% of the loan, whichever is lower. Instead of the money coming from the equity, it comes from calculating the cost differences between the old and the new loan.
Pros of a cash-out refinance
- Access more substantial sums of money
- May be less expensive than a HELOC
Cons of a cash-out refinance
- Increases your debt
- Exposes you to more asset risk
Pros of a limited cash-out refinance
- Can help to cover refinancing closing costs
- Doesn’t significantly increase your debt
Cons of a limited cash-out refinance
- Limits the amount of money you can receive
- Still responsible for closing costs (in the loan)
Terms and alternatives to consider
There’s a lot that you need to consider when deciding on a cash-out refinance. First, many people forget that you are getting a new loan when you refinance, which means more closing costs. For most loans, this is going to be several thousand dollars that you may not be prepared to pay. Certain circumstances may allow you to roll the closing costs into the new loan, but you’ll need to address that with the lender.
Most importantly, you’ll want to look at the new rates and terms of your new loan. A refinanced loan should be reviewed with the same scrutiny that you used with your first loan. Make sure that the interest rate, repayment terms, and the overall cost of the loan (over the lifetime) are numbers you are happy with.
Lastly, make sure you consider all of the available funding options at your disposal. Look at things like personal loans, home equity loans, home equity lines of credit (HELOCs), credit cards, and even borrowing from family and friends. The right option will depend on how much money you need, what you need it for, how quickly you need it, and what your financial situation looks like.
If you’re considering refinancing to get cash out or to get a better rate, a good first stop is a refinancing calculator. By taking a good look at the numbers, you can decide if refinancing is a good idea for you or not. The answer will ultimately depend on your current mortgage, your financial needs, and what the lenders are willing to offer you.